PEOPLEETHEREUM

Bankless: Ethereum poised to become the first profitable blockchain in history

2022/4/8

share

"Apple sells iPhones, Facebook sells users' attention, and blockchain sells blocks." - Ryan Sean Adams, founder of Bankless.

This article is authorized for reprint from BlockBeats, original source.

Profit = Total Revenue - Total Expenses

Advertisement - Please scroll down for more

Can this formula be applied to blockchain? Bankless' senior editor Lucas Campbell believes it can, and he thinks that a blockchain that cannot be profitable will not last long, but currently, no blockchain has achieved profitability.

The merge of Ethereum has shown him the dawn of profitability for blockchain. Why does blockchain need to be profitable, and why did Ethereum achieve profitability first? BlockBeats translates Lucas Campbell's latest article published on Bankless as follows:

The Business Model of Blockchain

The value of the US dollar benefits from the dominance of the United States.

The value of the Visa network lies in its role as a track of the financial system, connecting billions of participants in economic activities. As understood by the crypto natives, the issue lies in the lack of "security" in a social-political sense. These centralized entities provide a "settlement" layer, but ultimately, the settlement layer is controlled by centralized institutions, be it governments or corporations.

Blockchain provides a neutral alternative. The business of blockchain is to act as a secure settlement layer for value and to remain neutral through decentralization. Blockchain achieves this by selling blocks—each block can settle a limited number of transactions within a certain period. For example:

Bitcoin sells a block every 10 minutes, capable of accommodating 1MB of transactions. Ethereum sells a block every 15 seconds, capable of accommodating 80KB of transactions (equivalent to 4MB every 10 minutes).

Blocks process transactions, facilitating users' economic activities, including sending and receiving money, converting tokens, lending, collecting digital items, and any other programmable value.

From a business perspective, the product of blockchain is block space. The goal is to increase the value of block space and generate income from it.

So, what increases the value of block space? Security.

Poor blockchain security means transactions can be reversed or tampered with by attackers. Therefore, an insecure network is not a feasible settlement layer for value, especially when handling hundreds of billions of dollars daily.

The more secure a blockchain is, the more confident people are in transaction settlement, leading to an increased demand for block space. If a blockchain aims to become a global settlement layer, security becomes paramount.

However, security also comes at a cost for blockchain. To achieve this, blockchain uses token incentives to encourage people to allocate resources—usually computing power (PoW) or money (PoS)—to the network to ensure its security and protection from attacks.

Thus, security becomes the primary cost of blockchain.

Here, we can derive the core business model of public chains. Blockchain generates revenue from transaction fees, while its cost is the security expense paid through token incentives. In simple terms:

Net Profit = Transaction Fees - Token Incentives

Therefore, we can analyze "successful blockchain businesses" by comparing the security expenditure to the revenue generated from transaction fees. If a blockchain's security expenditure exceeds its income, a deficit will occur.

1/ L1 econ

Every layer 1 chain needs to be defended.

This costs money.

You pay for the defense in two ways.

1) Inflate your money supply
2) Tax blockspace sales

If your inflation costs exceed your tax revenue you're operating at a deficit. A deficit is not sustainable.

— RYAN SΞAN ADAMS – rsa.eth 🦇🔊 (@RyanSAdams) January 20, 2022

"Every L1 chain has to defend against attacks, and that costs money. You can fund yourself in two ways:

1. Increase the money supply
2. Tax the block space

If the cost of inflation exceeds tax revenue, you're in the red, and that's not sustainable."

As a crypto investor, the key is to find the most profitable blockchain businesses and invest in them. The best blockchain can sell its blocks at the highest price because people are willing to pay for it. This means that as a settlement layer, its product has a market foothold.

People are willing to spend thousands of dollars on an iPhone because they believe it is superior to other phones. Last year, iPhone's revenue accounted for less than 40% of the global smartphone market, but its profit accounted for over 75%.

Blockchain is no different. As long as a blockchain offers the best product (secure economic opportunities), entities are willing to pay higher transaction fees for it. The question is, who is the Apple of the blockchain industry?

Which Blockchains are Profitable?

The reality is that no blockchain is profitable today.

Currently, the major blockchain networks spend almost all of their token incentives on miners, exceeding the transaction fees they earn. They are operating unsustainable businesses.

You can see this in the chart below.

Ethereum generates nearly $13 million in transaction fees daily, making it the most valuable blockchain from this perspective. However, on the other hand, the network distributes 36 million USD worth of ETH to miners daily to generate these blocks. Therefore, Ethereum's current operational deficit is 64%.

The blockchain closest to profitability is BNB Chain, as it earns $1.4 million in transaction fees daily while only distributing $1.74 million in token incentives. At first glance, this may seem remarkable.

"It's time to mimic BNB."

However, the nuance lies in the fact that chains like Binance can entirely disregard the profitability comparison of L1 blockchains. This is because:

As mentioned earlier, when there is certainty in transaction settlement, block space becomes valuable. And this certainty comes at a cost.

BNB Chain is guarded by only 21 validation nodes. This is a closed and regulated entity. In other words, the centralized BNB Chain profits because it doesn't pay for security costs. These 21 validation nodes can easily collude, making transactions inconsequential, leading to the blockchain's value being significantly lower than an extremely decentralized and censorship-resistant network.

If BNB Chain truly valued high security, the cost would undoubtedly be higher. In comparison, Bitcoin spends $34.75 million in token incentives daily on 1 million miners, while Ethereum spends $36 million to secure the beacon chain on 276,000 validation nodes (pre-merge!!).

It is worth noting that reports suggest BNB Chain is influenced by money laundering transactions and spam transactions, disproportionately reporting higher revenue. (Of course, there are counterarguments to these claims, making it difficult to discern the truth).

For anyone who thinks the activity on #BSC is actually real, check this out

This one contract alone has had 680k failed transactions spammed to it within the past 17 hourshttps://t.co/JOaTXMpPFY@cz_binance please enlighten me and explain this obviously fabricated activity pic.twitter.com/NjONFbLg64

— ChainLinkGod.eth (@ChainLinkGod) February 19, 2021

But the truth is, except for Ethereum and BNB Chain, almost all major L1 operations are operating at around 90% deficits, or even worse.

Each L1 has built an impressive scalable infrastructure layer, while annually distributing billions of dollars in token incentives to ensure block security, but how about the demand for blocks?

Similarly, this is a trade-off. Trading on Avalanche or Solana is much cheaper than on Bitcoin or Ethereum, but cheapness has its costs, and these chains do not have enough revenue to offset their expenses.

How do you evaluate product demand: Product sales revenue.

How do you evaluate blockchain demand: Block space sales revenue.

Revenue is the true test of blockchain demand, not just the number of blocks sold.

What about Bitcoin?

Despite token incentives decreasing over the past decade (Bitcoin halving three times), the Bitcoin network still operates at a 98% loss rate. Even though the network plans to rely effectively on transaction fees by the end of this decade (after the fifth halving, over 95% of BTC will be mined), the network has not even come close to breaking even yet. Token incentives are nearing zero, but the network only pays for security, which we need to monitor closely.

The harsh reality is: building a profitable blockchain business is challenging.

Even Ethereum, with the most valuable block space, cannot achieve profitability in its current state, while Bitcoin's situation is even worse, on par with other L1 chains.

How is this Feasible at Present?

As a technology, blockchain is still in its early stages. Large-scale applications have not yet arrived, and there is still ample room for optimization in the technology itself, hence the current lack of profitability in blockchains—they are still self-sufficient.

This is very similar to internet companies of the 90s. Amazon was founded in 1994, but it was not profitable until 2001 when it reported a profit of $5 million from $1 billion in revenue.

This now multi-trillion-dollar company barely achieved profitability after 7 years.

Bitcoin has been around for 12 years, and Ethereum will celebrate its 7th anniversary this July, akin to the year 2000 for blockchains.

This leads to a question... Will blockchains achieve profitability in the same time frame as Amazon?

The Path to Profitability

So, what is the path to profitability for blockchains?

There are two main levers:

1. Increase transaction revenue
2. Reduce security expenses

1. Increase Transaction Revenue

The primary way blockchains increase transaction revenue is by increasing block utility—increasing the value of what can be done within each block. This can be achieved by building valuable applications to enhance network utility.

For instance, on Ethereum, anyone can swap $1 million in ETH for $1 million in DAI on Uniswap. This could be significant for some people. They are willing to pay a $10 transaction fee to settle this trade. In fact, perhaps they are willing to pay up to $1,000 in transaction fees.

Even in times of stress and volatility, they are willing to pay $10,000 to have their transaction processed immediately. A rational person is willing to pay a slightly higher price for a block than what they can extract from it.

As the application layer becomes more active, block space also becomes more valuable, as DeFi, NFTs, and other applications create economic opportunities within the block.

The revenue of block space is almost directly correlated with the number of valuable applications on the network and the opportunities they present.

This is even more apparent when looking at Bitcoin. Bitcoin essentially has only one use case—transferring BTC. Therefore, it is challenging for Bitcoin to generate a significant amount of block space revenue, as evidenced by its -98% profit margin.

One use case can only generate limited revenue.

With smart contract platforms, an unlimited number of applications can be built, allowing block space revenue to far exceed that of a blockchain with limited applications.

This is happening, with several smart contract platforms generating more transaction fee revenue than Bitcoin, including several Ethereum applications. The market is willing to pay more money to convert tokens on Ethereum than to transfer Bitcoin.

The key point is that block space revenue increases with block space utility—having more options. Block space utility expands with more tokens, more applications, and a more vibrant ecosystem.

It all depends on the decentralization and security of the network.

As mentioned earlier, if transactions can be reversed or censored, block space loses its value, and fewer applications will thrive on such a network.

2. Reduce Security Expenses

Increasing block space utility largely cannot be achieved through incentives alone. You need developers, applications, and users. In the long run, you can only incentivize users to use.

Therefore, the main path for blockchains to achieve sustainable development will be to reduce token incentives over time, reducing network expenses.

When reducing token incentives, the biggest cost is the reduction in security expenses. Unless prices rise, once the network reduces token incentives, the operational drive of validators/miners weakens, making the network less secure. While this doesn't happen every time, there is this risk whenever network demand is not balanced.

Blockchains must balance token incentives and block size. Many Alt L1 chains choose larger blocks to support more overall transactions, lowering the cost of individual transactions. Increasing block space supply makes it cheaper, but so far, it has proven challenging for blockchains to generate significant revenue.

Furthermore, increasing throughput at the base layer often creates a more centralized system, damaging the confidence foundation for the native currency on the chain to appreciate.

Blockchains must balance block space supply and the consequent token issuance. Generating blocks faster, creating larger blocks means greater network throughput, which must be secured by issuing more currency to ensure the security at that scale.

To achieve larger scale, more security costs must be spent.

You can see this impact in the inflation of smart contract chains.

• Ethereum: 4.20% inflation rate
• Solana: 9.15% inflation rate
• Avalanche: 26.6% inflation rate

Important Note: Ethereum is currently a proof-of-work chain, which is a resource-intensive security mechanism. Ethereum will transition to PoS later this year, reducing new ETH issuance by 90%, and Ethereum's annual inflation rate will drop to 0.4%.

Quick Supplement on L2

In increasing net revenue for blockchains, L2 can play a significant role.

According to CryptoFees.info data, Ethereum L2 generates $50,000 to $100,000 in revenue daily by selling block space. This is native revenue for L2, collected by L2 operators (potentially democratized through L2 native tokens in the future).

It's crucial that L2 has a demand for block space on Ethereum L1. L2 must consume L1 block space to "settle" with the blockchain mainnet. ETH burning rankings on UltraSound.Money includes Arbitrum, Polygon, and Optimism.

The core of L2 lies in that they don't need to pay for security costs with token issuance. They inherit their security from the "settlement" that occurs on L1. This makes deploying L2 insignificant, as many of the challenging parts of blockchain sustainability are addressed by leveraging L1 resources.

L2 operates like solar panels in economic activities. They offer users low fees and bundle user transactions into a package, batch deploying them to L1. This is where L2 usage can translate into L1 block space demand, and why a vibrant L2 ecosystem benefits L1 transaction fees.

Ethereum's scalability roadmap is impressive in that it sells block space to other blockchains (L2) rather than users. While individual users find Ethereum's gas fees unbearable, L2 blockchains are indifferent to L1 gas fees. And as users increase, they will have a greater demand for block space.

The First Profitable Blockchain is Coming

Through the merge, Ethereum is the first blockchain to embark on the path to economic sustainability. Later this year, possibly in June or July, the network will transition to a PoS consensus mechanism, reducing ETH issuance by 90%.

An interesting aspect of Ethereum's merge is that it is not just a mere reduction in issuance.

With improved security efficiency, the use of the "security budget" changes fundamentally. With the transition of the consensus algorithm and its improvements, PoS will make Ethereum more secure while reducing token issuance.

With the network reducing 90% of token issuance, the ETH distributed daily to stakers will be less than $4 million. It's important to note that Ethereum's transaction fees will not decrease with the merge.

This means that later this year, the network will distribute $4 million in token incentives daily, while generating $13 million in revenue, resulting in a net profit of $9 million and a 72% profit margin.

Ethereum, the first profitable blockchain!

It is worth emphasizing that with the merge, ETH also completes the three-point asset theory, fully transitioning into an interest-bearing asset.

All transaction fees generated by the network will flow to ETH holders through EIP 1559